Woods & Murphy Refute 11 Myths About The Fed

The other day the Huffington Post ran an article by a Bonnie Kavoussi called “11 Lies About the Federal Reserve.” And you’ll never guess: these aren’t lies or myths spread in the financial press by Fed apologists. These are “lies” being told by you and me, opponents of the Fed. Bonnie Kavoussi calls us “Fed-haters.” So she, a Fed-lover, is at pains to correct these alleged misconceptions. She must stop us stupid ingrates from poisoning our countrymen’s minds against this benevolent array of experts innocently pursuing economic stability.

Here are the 11 so-called lies (she calls them “myths” in the actual rendering), and my responses.

HuffPo’s Myth #1: “The Fed actually prints money.”

She leads off with this? As if this is some big discovery that will refute the end-the-Fed people? When we talk about Fed money-printing, we are speaking in shorthand. We’re pretty certain someone like Ron Paul knows the Fed doesn’t actually print money. But he, along with pretty much the whole financial world, speaks of the Fed as printing money. You know why? Because it’s a teensy bit more convenient than saying, “We need the Fed to credit some banks’ accounts with increased balances, which it does by means of a computer, though if these balances are lent out and the borrowers prefer to use some of this lent money as cash, the Treasury will go ahead and print the cash.”

HuffPo’s Myth #2:“The Federal Reserve is spending money wastefully.”

You may think the Federal Reserve is throwing around money like crazy, just like the federal government. But you’re wrong! As Kavoussi explains, the Fed doesn’t spend money like the federal government does; it creates money! That’s just totally different! And so we read, “Both CNN anchor Erin Burnett and Republican vice presidential nominee Paul Ryan have compared the Federal Reserve’s quantitative easing to government spending. But the Federal Reserve actually has created new money by expanding its balance sheet.”

She then points out that hey, the Fed earned a profit of $77.4 billion last year. We are supposed to be impressed. But if you can create money out of thin air and buy bonds with it, and then earn interest on those bonds, wouldn’t it be pretty hard to lose money? (But they just might, if interest rates should spike.)

HuffPo’s Myth #3: “The Fed is causing hyperinflation.”

Is it just us, or does Bonnie Kavoussi word things awkwardly? Do you know of anyone who says the Fed is causing – as in present progressive tense — hyperinflation?

Kavoussi then goes on to tell us that the CPI is showing low price inflation — again, as if she’s reporting some extraordinary revelation that will put all Fed critics to shame. There is no hyperinflation because the banks are holding the newly created money as excess reserves with the Fed. If the banks begin lending and the money multiplier is enacted, an inflationary spiral could easily occur — trillions of dollars of high-powered money would expand via the fractional-reserve banking system into tens of trillions of dollars. The only way for the government to stay ahead of the curve would be for the Fed to keep creating boatloads of new money — which is how hyperinflation happens, after all. If that were to happen, we rather doubt Kavoussi would want to come tell us how the CPI is doing.

“Some Federal Reserve critics claim that the Fed has devalued the U.S. dollar through a massive expansion of the amount of currency in circulation,” says Kavoussi. “But not only is inflation low; currency growth also has not really changed since the Fed started its stimulus measures, as noted by Business Insider’s Joe Weisenthal.”

This looks like another silly gotcha with definitions, like the “printing money” canard. The graph below shows that the currency component of M1 hasn’t shot up like a rocket, it’s true; but M1 itself (which consists of not just physical paper but also checking account deposits) has indeed risen sharply, notwithstanding the insights of Business Insider’s Joe Weisenthal.

HuffPo’s Myth #5: “The gold standard would make prices more stable.”

Kavoussi writes, “Rep. Ron Paul (R-Tex.) has claimed that bringing back the gold standard would make prices more stable. But prices actually were much less stable under the gold standard than they are today, as The Atlantic’s Matthew O’Brien and Business Insider’s Joe Weisenthal have noted.”

Does our critic even read the things she links to? Her two authors’ blog posts depict a very brief period in the twentieth century, after the classical gold standard had already given way to the gold exchange standard. What is that supposed to prove?

So against Bonnie Kavoussi’s two blog posts that examine the gold exchange standard and only for a period of about 15 years at that, all we have in reply is only the most meticulous study of gold and its purchasing power ever written, Roy Jastram’s The Golden Constant: The English and American Experience 1560-2007, which finds gold to be extraordinarily stable over four and a half centuries.

Even John Kenneth Galbraith, not exactly gold’s biggest fan, conceded that once someone had gold, there was little uncertainty about what he would be able to get with it. “In the last [19th] century in the industrial countries there was much uncertainty as to whether a man could get money but very little as to what it would do for him once he had it. In this [20th] century the problem of getting money, though it remains considerable, has diminished. In its place has come a new uncertainty as to what money, however acquired and accumulated, will be worth. Once, to have an income reliably denominated in money was thought…to be very comfortable. Of late, to have a fixed income is to be thought liable to impoverishment that may not be slow. What has happened to money?”

This can’t be, Kavoussi says, since some sources deny it. Bob Murphy testified before Congress on this very issue. He thinks the Fed does play a role. Where is the flaw in his reasoning?

HuffPo’s Myth #7: “Quantitative easing has not helped job growth.”

How could we think such a thing? Why, we should be satisfied to know, as Bonnie Kavoussi assures us, that “the Fed’s quantitative easing measures actually have saved or created more than 2 million jobs, according to the Fed’s economists.” Gee, the Fed’s economists think the Fed contributes to job growth? How about that! On the same grounds, we might say there was no housing bubble in 2005 and that the fundamentals of real estate were sound — after all, we could find a whole bunch of “Fed economists” who were saying just that.

In fact, these models build in the very assumptions about purchases helping the economy that they then spit out, just like with the ex post “analysis” of the Obama stimulus package. No matter what numbers one fed into such models, it would be impossible for them to say that QE (or the Obama stimulus) hindered economic growth; the worst they would show is a build-up of price inflation once “full employment” had been achieved.

HuffPo’s Myth #8: “Tying the U.S. dollar to commodities would solve everything.”

Whenever you hear a mocking writer like Bonnie Kavoussi say something like, “My opponents think X would solve everything,” you can be sure her opponents have said no such thing. Why, as a matter of simple courtesy, could she not simply have described this alleged myth as, “Tying the U.S. dollar to commodities would improve the American monetary system”? Because that might sound reasonable, and it’s Bonnie Kavoussi’s job to make her opponents sound like troglodytes.

HuffPo’s Myth #9: “Ending the Fed would make the financial system more stable.”

Here’s Bonnie Kavoussi: “Rep. Ron Paul (R-Tex.) claims that ending the Federal Reserve and returning to the gold standard would make the U.S. financial system more stable. But the U.S. economy actually experienced longer and more frequent financial crises and recessions during the 19th century, when the U.S. was using the gold standard and did not have the Fed.”

Categorically false. As wrong as wrong can be.

First, an excerpt from the 2011 Tom Woods book Rollback, whose chapter on the Fed spends some time on this claim. (We omit the notes here, but thanks go to George Selgin and Peter Klein for help with sources.)

When people raise questions about the utility of the Fed, they are usually lectured about how volatile the economy used to be and how much better it is now, thanks to the wise oversight of our central bank. Recent research has thrown cold water on this claim. Christina Romer finds that the numbers and dating used by the National Bureau of Economic Research (NBER, the largest economics research organization in the United States, founded in 1920) exaggerate both the number and the length of economic downturns prior to the creation of the Fed. In so doing, the NBER likewise overestimates the Fed’s contribution to economic stability. Recessions were in fact not more frequent in the pre-Fed than the post-Fed period.

But let’s be real sports about it, and compare only the post-World War II period to the pre-Fed period, thereby excluding the Great Depression from the Fed’s record. In that case, we do find economic contractions to be somewhat more frequent in the period before the Fed, but as economist George Selgin explains, “They were also almost three months shorter on average, and no more severe.” Recoveries were also faster in the pre-Fed period, with the average time peak to bottom taking only 7.7 months as opposed to the 10.6 months of the post-World War II period. Extending our pre-Fed period to include 1796 to 1915, economist Joseph Davis finds no appreciable difference between the length and duration of recessions as compared to the period of the Fed.

But perhaps the Fed has helped to stabilize real output (the total amount of goods and services an economy produces in a given period of time, adjusted to remove the effects of inflation), thereby decreasing economic volatility. Not so. Some recent research finds the two periods (pre- and post-Fed) to be approximately equal in volatility, and some finds the post-Fed period in fact to be more volatile, once faulty data are corrected for. The ups and downs in output that did exist before the creation of the Fed were not attributable to the lack of a central bank. Output volatility before the Fed was caused almost entirely by supply shocks that tend to affect an agricultural society (harvest failures and such), while output volatility after the Fed is to a much greater extend the fault of the monetary system.

When we look back at the nineteenth century, we discover that the monetary and banking instability that existed then were not caused by the absence of a government-established agency issuing unbacked paper money. According to Richard Timberlake, a well-known economist and historian of American monetary and banking history, “As monetary histories confirm…most of the monetary turbulence — bank panics and suspensions in the nineteenth century — resulted from excessive issues of legal-tender paper money, and they were abated by the working gold standards of the times.” In a nutshell, we are faced once again with the faults of interventionism being blamed on the free market.

Bonnie Kavoussi: “Many commentators have claimed that there simply aren’t any tools left in the Fed’s toolkit to be able to help job growth. But some economists have noted that the Fed could target a higher inflation rate to stimulate job growth.”

So we’re back to the old Phillips Curve analysis, which posited an inverse relationship between inflation and unemployment. You can get low unemployment, the argument went, but the price will be high inflation.

The theory was that there was a trade-off between unemployment and inflation. But if you go back to the original article by Phillips, he never demonstrates that such a thing exists in the real world. He manipulated and maneuvered the data around to make it look as if there was one. Once his errors are swept away, and the data broken down, the Phillips Curve vanishes as any kind of long-run pattern. It didn’t take stagflation to teach us that. It was always untrue.

This raises a much more interesting question. How did the idea ever come to dominate the macroeconomic literature in the first place? Here’s my theory. Recall that Keynesian theory suggests there are no downsides to manipulating aggregate demand through fiscal and monetary policy. If you created full employment, it would stay there and we’d all live happily ever after. It seems paradoxical, then, that Keynesians would embrace a theory that suggests that creating full employment risks generating inflation. Keynes never said that, but people like Paul Samuelson did...

It became fairly well recognized, even in the 1950s, that there could be such things as inflationary recessions. That put orthodox Keynesians in big trouble. In order to cover themselves, Samuelson and Solow adopted the Phillips Curve as a model. It served as the means to save themselves from the realization that Keynesianism was fundamentally flawed.

When inflation and unemployment increase, they don’t have to throw in the towel on Keynesian theory; they merely claim that the Phillips Curve has shifted outwards. They are saved–until of course the outward and inward shifts of the whole curve dominate movement along the curve. That means the supposed trade-off itself has disappeared. That’s exactly what happened. Many people see that the curve is now discredited. But in fact, it never did stand up. It was an escape hatch built by Keynesians that no longer allows them an escape.

For the systematic takedown of the Phillips Curve — if only Bonnie Kavoussi could recognize a real myth when she saw one, instead of just repeating what she learned in Ec 10 at Harvard — see chapter 3 of Dissent on Keynes.

Kavoussi: “Some commentators have claimed that the Fed can’t safely unwind its quantitative easing measures. But the Fed’s program involves buying some of the most heavily traded and owned securities in the world, Treasury and government-backed mortgage bonds. The Fed will likely have little problem finding buyers for these securities, all of which will eventually expire even if the Fed does nothing. But economists have noted that once the Fed decides it’s time to unwind the stimulus, the economy will have improved to such an extent that this won’t be an issue.”

Nobody is denying that the Fed could find a buyer for its assets. The issues are: (1) at what price will the Fed be able to unload those assets, and (2) what happens to the financial sector when the reserves are destroyed in the act of selling off these assets? The Fed could dump its entire holdings of Treasury securities tomorrow, but the critics are worried that this would send interest rates soaring and would cripple the banks which would no longer have excess reserves.

Look closely at what Kavoussi is saying: If the economy begins to recover before price inflation becomes a problem, then the Fed will be able to sit back and let its “stimulus” unwind naturally. Yes, great, but what if the economy is still in the toilet when price inflation heats up? Then, as Bob Murphy argues, all of the Fed’s ballyhooed “exit strategies” will seem pretty useless.

In short, it’s safe to say that there are indeed plenty of myths about the Fed, and that Bonnie Kavoussi believes pretty much all of them.